Understanding Equity Risk

Understanding Risk!
Aswath Damodaran

Aswath Damodaran! 1!
What is Risk?!
  Risk, in traditional terms, is viewed as a ‘negative’. Webster’s

dictionary, for instance, defines risk as “exposing to danger or
hazard”. The Chinese symbols for risk, reproduced below, give a
much better description of risk

危機

  The first symbol is the symbol for “danger”, while the second is the
symbol for “opportunity”, making risk a mix of danger and
opportunity.

Equity Risk!
  An equity investment in a business (private or public) entitles you to

residual earnings and cashflows. In other words, you are not promised
an interest rate but earn whatever is left over after you pay off other
investors.

  Models that try to measure equity risk vary across investors. Broadly
speaking, these risk and return models can be categorized as:

•  Theory based models that begin with an economic (and quantitative)
definition of risk and derive risk measures based on that definition.

•  Alternative models that are based upon either intuitive or qualitative
measures of risk.

I. Theory Based Models!
  Most theory based models begin by defining risk in terms of variance

in actual returns around expected returns.

  They usually measure risk through the eyes of the marginal investor in
equity (rather than the average investor). The marginal investor is an
investor who owns a large portion of the equity and trades frequently.

A. The Capital Asset Pricing Model!
  The capital asset pricing model is the oldest and still the most widely
used model for risk in the investment world.

  It is derived in four steps:

•  Uses variance as a measure of risk

•  Specifies that a portion of variance can be diversified away, and that is
only the non-diversifiable portion that is rewarded.

•  Measures the non-diversifiable risk with beta, which is standardized
around one.

•  Translates beta into expected return -

Expected Return = Riskfree rate + Beta * Risk Premium

Step 1: The Mean-Variance Framework!
  The variance on any investment measures the disparity between actual

and expected returns.
Low Variance Investment

High Variance Investment

Expected Return

Step 2: The Importance of Diversification: Risk
Types!
Figure 2.3: A Break Down of Risk
Competition
may be stronger
or weaker than Exchange rate
anticipated and Political
risk
Projects may
do better or Interest rate,
Entire Sector Inflation &
worse than may be affected
expected News about
by action Econoomy
Firm-specific Market
Actions/Risk that Actions/Risk that

affect only one affect all
firm Affects few Affects many investments
firms firms
The Effects of Diversification!
  Firm-specific risk can be reduced, if not eliminated, by increasing the

number of investments in your portfolio (i.e., by being diversified).
Market-wide risk cannot. This can be justified on either economic or
statistical grounds.

  On economic grounds, diversifying and holding a larger portfolio
eliminates firm-specific risk for two reasons-

•  (a) Each investment is a much smaller percentage of the portfolio, muting
the effect (positive or negative) on the overall portfolio.

•  (b) Firm-specific actions can be either positive or negative. In a large
portfolio, it is argued, these effects will average out to zero. (For every
firm, where something bad happens, there will be some other firm, where
something good happens.)

The Role of the Marginal Investor!
  The marginal investor in a firm is the investor who is most likely to be

the buyer or seller on the next trade.

  Since trading is required, the largest investor may not be the marginal
investor, especially if he or she is a founder/manager of the firm
(Michael Dell at Dell Computers or Bill Gates at Microsoft)

  In all risk and return models in finance, we assume that the marginal
investor is well diversified.

Step 3: The Market Portfolio!
  Assuming diversification costs nothing (in terms of transactions costs),

and that all assets can be traded, the limit of diversification is to hold a
portfolio of every single asset in the economy (in proportion to market
value). This portfolio is called the market portfolio.

  Individual investors will adjust for risk, by adjusting their allocations
to this market portfolio and a riskless asset (such as a T-Bill)

Preferred risk level

Allocation decision

No risk

100% in T-Bills

Some risk

50% in T-Bills; 50% in Market Portfolio;

A little more risk

25% in T-Bills; 75% in Market Portfolio

Even more risk

100% in Market Portfolio

A risk hog..

Borrow money; Invest in market portfolio;

  Every investor holds some combination of the risk free asset and the
market portfolio.

Step 4: The Risk of an Individual Asset!
  The risk of any asset is the risk that it adds to the market portfolio

  Statistically, this risk can be measured by how much an asset moves
with the market (called the covariance)

  Beta is a standardized measure of this covariance

  Beta is a measure of the non-diversifiable risk for any asset can be
measured by the covariance of its returns with returns on a market
index, which is defined to be the asset's beta.

  The cost of equity will be the required return,

Cost of Equity = Rf + Equity Beta * (E(Rm) - Rf)

where,

Rf = Riskfree rate

E(Rm) = Expected Return on the Market Index


Using the CAPM: The basic inputs!
(a) the current risk-free rate

(b) the expected market risk premium (the premium expected for
investing in risky assets over the riskless asset)

(c) the beta of the asset being analyzed.


The Riskfree Rate and Time Horizon!
  On a riskfree asset, the actual return is equal to the expected return.

  Therefore, there is no variance around the expected return.

  For an investment to be riskfree, i.e., to have an actual return be equal
to the expected return, two conditions have to be met –

•  There has to be no default risk, which generally implies that the security
has to be issued by the government. Note, however, that not all
governments can be viewed as default free.

•  There can be no uncertainty about reinvestment rates, which implies that it
is a zero coupon security with the same maturity as the cash flow being
analyzed.


Riskfree Rate in Practice!
  The riskfree rate is the rate on a zero coupon government bond

matching the time horizon of the cash flow being analyzed.

  Theoretically, this translates into using different riskfree rates for each
cash flow - the 1 year zero coupon rate for the cash flow in year 2, the
2-year zero coupon rate for the cash flow in year 2 ...

  Practically speaking, if there is substantial uncertainty about expected
cash flows, the present value effect of using time varying riskfree rates
is small enough that it may not be worth it.


The Bottom Line on Riskfree Rates!
  Using a long term government rate (even on a coupon bond) as the

riskfree rate on all of the cash flows in a long term analysis will yield a
close approximation of the true value.

  For short term analysis, it is entirely appropriate to use a short term
government security rate as the riskfree rate.


Measurement of the risk premium!
  The risk premium is the premium that investors demand for investing
in an average risk investment, relative to the riskfree rate.

  As a general proposition, this premium should be

•  greater than zero

•  increase with the risk aversion of the investors in that market

•  increase with the riskiness of the “average” risk investment


What is your risk premium?!
  Assume that stocks are the only risky assets and that you are offered
two investment options:

•  a riskless investment (say a Government Security), on which you can
make 5%

•  a mutual fund of all stocks, on which the returns are uncertain

How much of an expected return would you demand to shift your money
from the riskless asset to the mutual fund?

  Less than 5%

  Between 5 - 7%

  Between 7 - 9%

  Between 9 - 11%

  Between 11- 13%

  More than 13%


Risk Aversion and Risk Premiums!
  If this were the capital market line, the risk premium would be a
weighted average of the risk premiums demanded by each and every
investor.

  The weights will be determined by the magnitude of wealth that each
investor has. Thus, Warren Bufffet’s risk aversion counts more
towards determining the “equilibrium” premium than yours’ and
mine.

  As investors become more risk averse, you would expect the
“equilibrium” premium to increase.


Estimating Risk Premiums in Practice!
  Survey investors on their desired risk premiums and use the average
premium from these surveys.

  Assume that the actual premium delivered over long time periods is
equal to the expected premium - i.e., use historical data

  Estimate the implied premium in today’s asset prices.


The Survey Approach!
  Surveying all investors in a market place is impractical.

  However, you can survey a few investors (especially the larger
investors) and use these results. In practice, this translates into surveys
of money managers’ expectations of expected returns on stocks over
the next year.

  The limitations of this approach are:

•  there are no constraints on reasonability (the survey could produce
negative risk premiums or risk premiums of 50%)

•  they are extremely volatile

•  they tend to be short term; even the longest surveys do not go beyond one
year


The Historical Premium Approach!
  This is the default approach used by most to arrive at the premium to

use in the model

  In most cases, this approach does the following

•  it defines a time period for the estimation (1926-Present, 1962-Present....)

•  it calculates average returns on a stock index during the period

•  it calculates average returns on a riskless security over the period

•  it calculates the difference between the two

•  and uses it as a premium looking forward

  The limitations of this approach are:

•  it assumes that the risk aversion of investors has not changed in a
systematic way across time. (The risk aversion may change from year to
year, but it reverts back to historical averages)

•  it assumes that the riskiness of the “risky” portfolio (stock index) has not
changed in a systematic way across time.


Historical Average Premiums for the United
States!

"
"
Arithmetic Average"

Geometric Average"
Stocks - T. Bills" Stocks - T. Bonds" Stocks - T. Bills" Stocks - T. Bonds"

1928-2011" 7.55%" 5.79%" 5.62%" 4.10%"
" 2.22%" 2.36%" " "

1962-2011" 5.38%" 3.36%" 4.02%" 2.35%"

"
2002-2011"
2.39%"
3.12%"
2.68%"
-1.92%"
"
1.08%"
"
-3.61%"

" 6.46%" 8.94%" " "

What is the right premium?

  Go back as far as you can. Otherwise, the standard error in the
estimate will be large.

  Be consistent in your use of a riskfree rate.

  Use arithmetic premiums for one-year estimates of costs of equity and
geometric premiums for estimates of long term costs of equity.


What about historical premiums for other markets?

  Historical data for markets outside the United States is available for
much shorter time periods. The problem is even greater in emerging
markets.

  The historical premiums that emerge from this data reflects this data
problem and there is much greater error associated with the estimates
of the premiums.


One solution: Look at a country’s bond rating and
default spreads as a start

  Ratings agencies assign ratings to countries that reflect their

assessment of the default risk of these countries. These ratings reflect
the political and economic stability of these countries and thus provide
a useful measure of country risk.

•  In May 2009, the local currency rating, from Moody’s, for Brazil was
Ba1. In May 2009, Brazil had dollar denominated 10-year Bonds, trading
at an interest rate of 6%. The US treasury bond rate that day was 3.5%,
yielding a default spread of 2.50% for Brazil.

•  India has a rating of Ba2 from Moody’s but has no dollar denominated
bonds. The typical default spread for Ba2 rated sovereign bonds is 3%.

  Many analysts add this default spread to the US risk premium to come
up with a risk premium for a country. This would yield a risk premium
of 6.38% for Brazil and 6.88% for India, if we use 3.88% as the
premium for the US .


Beyond the default spread

  While default risk spreads and equity risk premiums are highly correlated, one
would expect equity spreads to be higher than debt spreads. In fact, one
simple way to adjust the default spread for the additional risk in the equity
market is to multiply it by the relative volatility (standard deviation of
equities/ standard deviation of government bond)

  Risk Premium for Brazil in early 2009

•  Standard Deviation in Bovespa (Equity) = 34%

•  Standard Deviation in Brazil $ denominated Bond = 21.5%

•  Default spread on $ denominated Bond = 2.5%

•  Country Risk Premium (CRP) for Brazil = 2.5% (34%/21.5%) = 3.95%

•  Total Risk Premium for Brazil = US risk premium (in ‘09) + CRP for
Brazil = 3.88% + 3.95% = 7.83%


Albania
12.00%

Bangladesh
10.88%

Armenia
10.13%

Austria [1]
6.00%
Cambodia
13.50%

Azerbaijan
9.60%

Belgium [1]
7.05%
China
7.05%

Country Risk Premiums! Cyprus [1]
9.00%

Belarus
15.00%

Fiji Islands
12.00%

Bosnia and
January 2012! Denmark
6.00%
Herzegovina
13.50%

Hong Kong
6.38%

Finland [1]
6.00%
India
9.00%

Bulgaria
8.63%

France [1]
6.00%
Indonesia
9.60%

Croatia
9.00%

Germany [1]
6.00%
Japan
7.05%

Canada
6.00%
Czech Republic
7.28%

Greece [1]
9.00%
Korea
7.28%

United States of America
6.00%
Estonia
7.28%

Iceland
9.00%
Macao
7.05%

Georgia
10.88%

Ireland [1]
9.60%
Malaysia
7.73%

Hungary
9.60%

Italy [1]
7.50%
Mongolia
12.00%

Kazakhstan
8.63%

Argentina
15.00%
Malta [1]
7.50%
Pakistan
15.00%

Latvia
9.00%

Belize
15.00%
Netherlands [1]
6.00%
Papua New
Lithuania
8.25%
Guinea

Bolivia
12.00%
Norway
6.00%
12.00%

Moldova
15.00%

Brazil
8.63%
Portugal [1]
10.13%
Philippines
10.13%

Montenegro
10.88%

Chile
7.05%
Spain [1]
7.28%
Singapore
6.00%

Poland
7.50%

Colombia
9.00%
Sweden
6.00%
Sri Lanka
12.00%

Romania
9.00%

Costa Rica
9.00%
Switzerland
6.00%
Taiwan
7.05%

Russia
8.25%

Ecuador
18.75%
United Kingdom
6.00%
Thailand
8.25%

Slovakia
7.28%

El Salvador
10.13%
Turkey
10.13%

Slovenia [1]
7.28%

Guatemala
9.60%
Vietnam
12.00%

Ukraine
13.50%

Honduras
13.50%
Angola
10.88%

Mexico
8.25%
Botswana
7.50%
Australia
6.00%

Bahrain
8.25%

Nicaragua
15.00%
Egypt
13.50%
New Zealand
6.00%

Israel
7.28%

Panama
9.00%
Mauritius
8.63%
Jordan
10.13%

Paraguay
12.00%
Morocco
9.60%
Kuwait
6.75%

Peru
9.00%
Namibia
9.00%
Lebanon
12.00%

Uruguay
9.60%
South Africa
7.73%
Oman
7.28%

Venezuela
12.00%
Tunisia
9.00%
Qatar
6.75%

Saudi Arabia
7.05%

Senegal
12.00%

Aswath Damodaran! United Arab Emirates
6.75%
26!
An Alternative Approach: Watch what I pay, not
what I say…

  On January 1, 2012, the S&P 500 was at 1257.60, essentially

unchanged for the year. And it was a year of macro shocks – political
upheaval in the Middle East and sovereign debt problems in Europe.
The treasury bond rate dropped below 2% and buybacks/dividends
surged.

In the trailing 12 months, the
cash returned to stockholders Analysts expect earnings to grow 9.6% in 2012, 11.9% in 2013, After year 5, we will assume that
was 74.17. Using the average 8.2% in 2014, 4.5% in 2015 and 2% therafter, resulting in a
earnings on the index will grow at
cash yield of 4.71% for compounded annual growth rate of 7.18% over the next 5 years. We
1.87%, the same rate as the entire
2002-2011 the cash returned will assume that dividends & buybacks will grow 7.18% a year for
economy (= riskfree rate).
would have been 59.29. the next 5 years.
63.54 68.11 73.00 78.24 83.86 Data Sources:

Dividends and Buybacks
last year: S&P
63.54 68.11 73.00 78.24 83.86 83.86(1.0187) Expected growth rate:
1257.60 = + + + + +
January 1, 2012 (1+ r) (1+ r) (1+ r) (1+ r) (1+ r) (r −.0187)(1+ r)5
2 3 4 5
News stories, Yahoo!
S&P 500 is at 1257.60 Finance, Bloomberg
Adjusted Dividends & Expected Return on Stocks (1/1/12) = 7.91%
Buybacks for 2011 = 59.29 T.Bond rate on 1/1/12 = 1.87%
Equity Risk Premium = 7.91% - 1.87% = 6.04%

Implied Premiums in the US: 1960-2011


Firm Specific and Market Risk!
  The R squared (R2) of the regression provides an estimate of the

proportion of the risk (variance) of a firm that can be attributed to
market risk;

  The balance (1 - R2) can be attributed to firm specific risk.


Beta Estimate: Disney – 2004-2008!

Estimating Expected Returns for Disney in May
2009

  Inputs to the expected return calculation

•  Disney’s Beta = 0.95

•  Riskfree Rate = 3.50% (U.S. ten-year T.Bond rate in May 2009)

•  Risk Premium = 6% (Based on updated implied premium at the start of
2009)

  Expected Return
= Riskfree Rate + Beta (Risk Premium)

= 3.50% + 0.95 (6.00%) = 9.2%


Use to a Potential Investor in Disney

As a potential investor in Disney, what does this expected return of 9.2%

tell you?

a)  This is the return that I can expect to make in the long term on Disney, if
the stock is correctly priced and the CAPM is the right model for risk,

b)  This is the return that I need to make on Disney in the long term to break
even on my investment in the stock

c)  Both

Assume now that you are an active investor and that your research
suggests that an investment in Disney will yield 12.5% a year for the
next 5 years. Based upon the expected return of 9.2%, you would

a)  Buy the stock

b)  Sell the stock


Myths about beta!
  Beta is a measure of overall risk: It is not. It measures only exposure to

macro or market risk. Thus, volatile investments can have low betas, if
the bulk of their risk is specific to the investment.

  Beta is a statistical measure: While betas might be estimated from
regressions, they are determined by three fundamental decisions that a
firm makes: the business it is in, its fixed cost structure and its
financial leverage.

  Beta is a fact: It is not. It is an estimate and a single regression beta
can have a very high standard error.

  Beta measures investment quality: It does not. It measures investment
risk. Thus, you can have a great investment with a low beta, an
average beta or a high beta.


Limitations of the CAPM!
  1. The model makes unrealistic assumptions

  2. The parameters of the model cannot be estimated precisely

•  - Definition of a market index

•  - Firm may have changed during the 'estimation' period'

  3. The model does not work well

•  - If the model is right, there should be

–  a linear relationship between returns and betas

–  the only variable that should explain returns is betas

•  - The reality is that

–  the relationship between betas and returns is weak

–  Other variables (size, price/book value) seem to explain differences in returns
better.


B. Alternatives to the CAPM!
Step 1: Defining Risk
The risk in an investment can be measured by the variance in actual returns around an
expected return
Riskless Investment Low Risk Investment High Risk Investment
E(R) E(R) E(R)

Step 2: Differentiating between Rewarded and Unrewarded Risk
Risk that is specific to investment (Firm Specific) Risk that affects all investments (Market Risk)
Can be diversified away in a diversified portfolio Cannot be diversified away since most assets
1. each investment is a small proportion of portfolio are affected by it.
2. risk averages out across investments in portfolio
The marginal investor is assumed to hold a “diversified” portfolio. Thus, only market risk will
be rewarded and priced.
Step 3: Measuring Market Risk
The CAPM The APM Multi-Factor Models Proxy Models
If there is If there are no Since market risk affects In an efficient market,
1. no private information arbitrage opportunities most or all investments, differences in returns
2. no transactions cost then the market risk of it must come from across long periods must
the optimal diversified any asset must be macro economic factors. be due to market risk
portfolio includes every captured by betas Market Risk = Risk differences. Looking for
traded asset. Everyone relative to factors that exposures of any variables correlated with
will hold this market portfolio affect all investments. asset to macro returns should then give
Market Risk = Risk Market Risk = Risk economic factors. us proxies for this risk.
added by any investment exposures of any Market Risk =
to the market portfolio: asset to market Captured by the
factors Proxy Variable(s)
Beta of asset relative to Betas of asset relative Betas of assets relative Equation relating
Market portfolio (from to unspecified market to specified macro returns to proxy
a regression) factors (from a factor economic factors (from variables (from a
analysis) a regression) regression)

II. Alternative models of Equity Risk!
  There are many who find theory based models of equity risk lacking
because

•  They look at both upside and downside volatility (it is only the latter that
investors don’t like)

•  They are based upon market prices rather than fundamentals

•  They break risk down into diversifiable and non-diversifiable components,
a break down that may have no relevance if you are only minimally
diversified.

  The alternative models for equity risk can broadly be classified as

•  Models that are based upon accounting statements

•  Proxy models (where something else stands in for risk)

•  Market implied measures of risk

•  Risk adjusted earnings/ cash flows

•  Margin of Safety

a. Accounting based risk measures!
  Accounting Ratio: Pick an accounting ratio, and scale risk to this ratio.
Thus, the median book debt to capital ratio for US companies at the
start of 2011 was 51%. The book debt to capital ratio for 3M at that
time 30.91%, yielding a relative risk measure of 0.61 for the company,
obtained by dividing 3M’s debt ratio (30.91%) by the market average
(51%).

  Compute an accounting beta: Look at changes in accounting earnings
at a firm, relative to accounting earnings for the entire market. Firms
that have more stable earnings than the rest of the market or whose
earnings movements have nothing to do with the rest of the market
will have low accounting betas.


b. Proxy Models!
  Look at returns on individual stocks over long periods and search for
characteristics shared by companies that earn high returns.

  This approach was kicked off by Fama and French, who found that
low price to book and small market cap stocks earned higher returns
than the rest of the market. In the years since, there have been
additional three additional variables that seem to be correlated with
returns:

•  Earnings momentum: Companies that have reported stronger than
expected earnings growth in the past earn higher returns than the rest of
the market.

•  Price momentum: Returns are higher for stocks that have outperformed
markets in recent time periods and lower for stocks that have lagged.

•  Liquidity: Stocks that are less liquid (lower trading volume, higher bid-
ask spreads) earn higher returns than more liquid stocks.


c. Market Implied risk measures!
  If you can observe the price of a risky asset, and you can estimate the
expected cash flows on that asset, you can back out the market’s
implied “required return” for that asset.

  With bonds, we use promised coupons and the face value, in
conjunction with the price of the bond today to compute yields to
maturity.

  With stocks, with we can used expected dividends or cash flows
together with the stock price to get an expected return on the stock.


d. Risk adjusted cash flows!
  Risk adjusting the cash flows requires more than taking the expected
cash flow across all scenarios, good and bad. You have to convert
these expected cash flows into certainty equivalent cash flows.

  There are two practical approaches to computing certainty equivalent
cash flows. .

•  In the first, you consider only those cash flows from a business that are
"safe" and that you can count on, when you do valuation. If you do so, and
you are correct in your assessment, you don't have to risk adjust the cash
flows.

•  The second variant is an interesting twist on dividends and a throw back
to Ben Graham. To the extent that companies are reluctant to cut
dividends, once they initiate them, it can be argued that the dividends paid
by a company reflects its view of how much of its earnings are certain.


e. Margin of Safety!
  The "margin of safety" has a long history in value investing. While the
term may have been in use prior to 1934, Graham and Dodd argued
that investors should buy stocks that trade at significant discounts on
value and developed screens that would yield these stocks.

  To put into practice the margin of safety (MOS), investors have to

•  Screen for companies that meets good company criteria: solid
management, good product and sustainable competitive advantages.

•  Estimate intrinsic value. Value investors use a variety of approaches in
this endeavor: some use discounted cash flow, some use relative valuation
and some look at book value.

•  . The third step in the process is to compare the price to the intrinsic value
and that is where the MOS comes in: with a margin of safety of 40%, you
would only buy an asset if its price was more than 40% below its intrinsic
value.


Propositions about MOS!
Proposition 1: MOS comes into play at the end of the investment process,
not at the beginning.

Proposition 2: MOS does not substitute for risk assessment and intrinsic
valuation, but augments them.

Proposition 3: The MOS cannot and should not be a fixed number, but
should be reflective of the uncertainty in the assessment of intrinsic value.

Proposition 4: Being too conservative can be damaging to your long term
investment prospects.


Final thoughts about equity risk!
  a. Explicit versus implicit: There are plenty of analysts who steer away
from discounted cash flow valuation and use relative valuation
(multiples and comparable firms) because they are uncomfortable with
measuring risk explicitly. The danger with implicit assumptions is that
you can be lulled into a false sense of complacency, even as
circumstances change.

  b. Quantitative versus qualitative: Analysts who use conventional risk
and return models are accused of being too number oriented and not
looking at qualitative factors enough. Perhaps, but the true test of
whether you can do valuation is whether you can take stories that you
hear about companies and convert them into numbers for the future.

  c. Simple versus complicated: Sometimes, less is more and you get
your best assessments when you keep things simple.


What is debt?!
  General Rule: Debt generally has the following characteristics:

•  Commitment to make fixed payments in the future

•  The fixed payments are tax deductible

•  Failure to make the payments can lead to either default or loss of control
of the firm to the party to whom payments are due.

  As a consequence, debt should include

•  Any interest-bearing liability, whether short term or long term.

•  Any lease obligation, whether operating or capital.


Measuring Bond Risk: Default Risk!
  When you buy a bond, you are promised a fixed payment (the interest
rate on the bond). The best case scenario for you is that you receive
that fixed payment. The worse case scenarios have a much wider
range, with the worst case scenario being that you do not receive any
of your promised cash flows.

  Since the potential for upside is limited and for downside is very large,
we measure risk in bonds by looking at the downside or default risk.


Determinants of Default Risk!
  Capacity to generate cashflows from operations: The larger the

cashflows that you generate from operations, the lower your default
risk should be.

  Volatility in these cashflows: The more predictable your cashflows are,
the lower your default risk should be.

  Fixed Commitments: The larger your commitments (interest and
principal payments), relative to your operating cashflows, the greater is
your default risk.


Measuring Default Risk!
  Credit Risk Scores: For as long as institutions and individuals have

been lending money, they have been using both qualitative and
quantitative factors to measure the credit risk of borrowers.

  Bond Ratings: Publicly traded companies that desire to access the
bond market (where individual investors may lack the resources and
the incentives to measure default risk on their own) have been rated by
ratings agencies.


The Ratings Process!
THE RATINGS PROCESS
Issuer or Requestor
authorized completes S&P S&P assigns Analysts
representative rating request form analytical research S&P
request rating and issue is team to issue library,
entered into S&P's internal files
administrative and and data bases
control systems.
Final Analytical Issuer meeting:

review and presentation to
preparation S&P personnel
of rating or
committee S&P personnel
presentation tour issuer
facilities
Presentation of Notification of Does issuer Format

the analysis to the rating decision wish to appeal No notification to
S&P rating to issuer or its by furnishing issuer or its
commitee authorized additional authorized
Discussion and representative information? representative:
vote to determine Rating is
rating Yes released
Presentation of
additional
information to
S&P rating
committee:
Discussion and
vote to confirm
or modify rating.

Ratings and Financial Ratios!
AAA AA A BBB BB B CCC

EBIT interest cov. (x) 17.5 10.8 6.8 3.9 2.3 1.0 0.2
EBITDA interest cov. 21.8 14.6 9.6 6.1 3.8 2.0 1.4
Funds flow/total debt 105.8 55.8 46.1 30.5 19.2 9.4 5.8
Free oper. cash 55.4 24.6 15.6 6.6 1.9 –4.5 -14.0
flow/total debt (%)
Return on capital (%) 28.2 22.9 19.9 14.0 11.7 7.2 0.5
Oper.income/sales 29.2 21.3 18.3 15.3 15.4 11.2 13.6
(%)
Long-term 15.2 26.4 32.5 41.0 55.8 70.7 80.3
debt/capital (%)
Total Debt/ Capital 26.9 35.6 40.1 47.4 61.3 74.6 89.4
(%)
Number of firms 10 34 150 234 276 240 23

From Ratings to Default Spreads!

Updated Default Spreads – January 2012

Ra#ng 1 year 5 year 10 year 30 year
Aaa/AAA 0.35% 0.70% 0.65% 0.85%
Aa1/AA+ 0.45% 0.75% 0.80% 1.10%
Aa2/AA 0.50% 0.80% 0.95% 1.15%
Aa3/AA-‐ 0.60% 0.85% 1.05% 1.20%
A1/A+ 0.65% 0.90% 1.15% 1.30%
A2/A 0.80% 1.05% 1.20% 1.40%
A3/A-‐ 0.95% 1.25% 1.45% 1.65%
Baa1/BBB+ 1.20% 1.70% 2.00% 2.20%
Baa2/BBB 1.30% 2.05% 2.30% 2.50%
Baa3/BBB-‐ 2.00% 2.80% 3.10% 3.25%
Ba1/BB+ 4.00% 4.00% 3.75% 3.75%
Ba2/BB 4.50% 5.50% 4.50% 4.75%
Ba3/BB-‐ 4.75% 5.75% 4.75% 5.25%
B1/B+ 5.75% 6.75% 5.50% 5.50%
B2/B 6.25% 7.75% 6.50% 6.00%
B3/B-‐ 6.50% 9.00% 6.75% 6.25%
Caa/CCC 7.25% 9.25% 8.75% 8.25%
CC 8.00% 9.50% 9.50% 9.50%
C 9.00% 10.00% 10.50% 10.50%
D 10.00% 12.00% 12.00% 12.00%

Estimating the Cost of Debt!
  If the firm has bonds outstanding, and the bonds are traded, the yield to
maturity on a long-term, straight (no special features) bond can be
used as the interest rate.

  If the firm is rated, use the rating and a typical default spread on bonds
with that rating to estimate the cost of debt.

  If the firm is not rated,

•  and it has recently borrowed long term from a bank, use the interest rate
on the borrowing or

•  estimate a synthetic rating for the company, and use the synthetic rating to
arrive at a default spread and a cost of debt


Estimating Synthetic Ratings!
  The rating for a firm can be estimated using the financial

characteristics of the firm. In its simplest form, the rating can be
estimated from the interest coverage ratio

Interest Coverage Ratio = EBIT / Interest Expenses

  For a firm, which has earnings before interest and taxes of $ 3,500
million and interest expenses of $ 700 million

Interest Coverage Ratio = 3,500/700= 5.00

•  Based upon the relationship between interest coverage ratios and ratings,
we would estimate a rating of A for the firm.


Interest Coverage Ratios, Ratings and Default
Spreads!

In closing…!
  Higher risk investments should earn higher expected returns.

  The way we measure risk is different for equity investments (stocks)
and bonds.

•  With stocks, we make the assumption that the risk that matters is risk that
cannot be diversified. This non-diversifiable risk is measured with one
beta (in the CAPM) or multiple betas (with more complex risk and return
models).

•  With bonds, we measure risk as default risk.


Understanding Equity Risk

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Understanding Risk!

 Risk, in traditional terms, is viewed as a ‘negative’. Webster’s

 An equity investment in a business (private or public) entitles you to

 Most theory based models begin by defining risk in terms of variance

 The variance on any investment measures the disparity between actual

High Variance Investment

Figure 2.3: A Break Down of Risk

Actions/Risk that Actions/Risk that

 Firm-specific risk can be reduced, if not eliminated, by increasing the

 The marginal investor in a firm is the investor who is most likely to be

 Assuming diversification costs nothing (in terms of transactions costs),

Aswath Damodaran! 11!

(a) the current risk-free rate

Aswath Damodaran! 12!

 On a riskfree asset, the actual return is equal to the expected return.

Aswath Damodaran! 13!

 The riskfree rate is the rate on a zero coupon government bond

Aswath Damodaran! 14!

 Using a long term government rate (even on a coupon bond) as the

Aswath Damodaran! 15!

Aswath Damodaran! 16!

Aswath Damodaran! 17!

Aswath Damodaran! 18!

Aswath Damodaran! 19!

 Surveying all investors in a market place is impractical.

Aswath Damodaran! 20!

 This is the default approach used by most to arrive at the premium to

Aswath Damodaran! 21!

Aswath Damodaran! 22!

Aswath Damodaran! 23!

 Ratings agencies assign ratings to countries that reflect their

Aswath Damodaran! 24!

Aswath Damodaran! 25!

 On January 1, 2012, the S&P 500 was at 1257.60, essentially

63.54 68.11 73.00 78.24 83.86 Data Sources:

Aswath Damodaran! 27!

Aswath Damodaran! 28!

 The R squared (R2) of the regression provides an estimate of the

Aswath Damodaran! 29!

Aswath Damodaran! 30!

 Inputs to the expected return calculation

Aswath Damodaran! 31!

As a potential investor in Disney, what does this expected return of 9.2%

Aswath Damodaran! 32!

 Beta is a measure of overall risk: It is not. It measures only exposure to

Aswath Damodaran! 33!

 1. The model makes unrealistic assumptions

Aswath Damodaran! 34!

E(R) E(R) E(R)

Aswath Damodaran! 35!

Aswath Damodaran! 37!

Aswath Damodaran! 38!

Aswath Damodaran! 39!

Aswath Damodaran! 40!

Aswath Damodaran! 41!

Aswath Damodaran! 42!

Aswath Damodaran! 43!

 General Rule: Debt generally has the following characteristics:

Aswath Damodaran! 44!

Aswath Damodaran! 45!

 Capacity to generate cashflows from operations: The larger the

Aswath Damodaran! 46!

  Risk, in traditional terms, is viewed as a ‘negative’. Webster’s

  An equity investment in a business (private or public) entitles you to

  Most theory based models begin by defining risk in terms of variance

  The variance on any investment measures the disparity between actual

  Firm-specific risk can be reduced, if not eliminated, by increasing the

  The marginal investor in a firm is the investor who is most likely to be

  Assuming diversification costs nothing (in terms of transactions costs),

  On a riskfree asset, the actual return is equal to the expected return.

  The riskfree rate is the rate on a zero coupon government bond

  Using a long term government rate (even on a coupon bond) as the

  Surveying all investors in a market place is impractical.

  This is the default approach used by most to arrive at the premium to

  Ratings agencies assign ratings to countries that reflect their

  On January 1, 2012, the S&P 500 was at 1257.60, essentially

  The R squared (R2) of the regression provides an estimate of the

  Inputs to the expected return calculation

  Beta is a measure of overall risk: It is not. It measures only exposure to

  1. The model makes unrealistic assumptions

  General Rule: Debt generally has the following characteristics:

  Capacity to generate cashflows from operations: The larger the

  Credit Risk Scores: For as long as institutions and individuals have

  The rating for a firm can be estimated using the financial

  Higher risk investments should earn higher expected returns.